In-Transit Inventory Finance: Understanding the Rights of an Unpaid Seller

Reprinted from the March 2013 Issue of The Secured Lender.

In a world of ever-increasing outsourced manufacturing, an asset-based lender faces increasing challenges when providing inventory financing.  Under a typical asset-based credit facility, the borrower obtains borrowing availability based on the value of inventory at its place of business.  However, the borrower may be hampered in creating availability when inventory production is outsourced because all its inventory is produced off-site.  There may be occasions when the borrower needs availability under its credit facility prior to receipt of the inventory.  Allowing inventory to be eligible while in transit from the supplier generates a new risk for the lender:  claims by an unpaid seller. 

The Uniform Commercial Code (the "UCC") affords a seller certain rights in the inventory that it has sold but for which it has not yet been paid.[i]  A seller can reserve title to the inventory in the purchase documents, may be able to stop the delivery of inventory while in transit, and may automatically acquire a perfected security interest when certain shipping documents are used to transport the inventory.  In many cases, the seller's interest in the inventory trumps the rights of a lender even if the lender has previously been granted and perfected a security interest in after-acquired inventory.  The discussion below highlights the various business risks the lender faces when the seller remains unpaid and suggests the steps the lender should take to address those risks.

Seller's Reservation of Title. The lender's review of the sales contract may be complicated by the fact that not all contracts are contained in a single written agreement that captures the entire business deal of the parties.  In some cases, the contract consists of purchase orders, purchase order confirmations, invoices and even e-mail messages.  Accordingly, the lender should review the relevant documentation to confirm whether any of the component documents provide for a reservation of title in favor of the seller.The first step in analyzing the unpaid seller's rights is to review the underlying contract to determine whether the seller has reserved title to the inventory until it is paid for such inventory.  A seller's reservation of title to inventory creates a security interest in favor of the seller.[ii] 

If the sales contract includes a reservation of title, then the seller's resulting security interest is perfected under the UCC automatically without the need to file a financing statement.  The security interest remains perfected until the borrower obtains "possession" of the inventory, and during that time is superior to conflicting security interests in the inventory, including prior perfected security interests.[iii]  Once the borrower obtains possession, automatic perfection ceases and the seller must file a financing statement to retain a perfected security interest.[iv]

When does the borrower obtain "possession"?  The best indicator is the borrower's physical possession of the inventory at its place of business.[v]  Possession on the borrower's behalf by a warehouse or processor may also suffice.  Although case law is not entirely uniform, many courts examine whether the borrower has the right to control the inventory once it is received by the third party.  If so, the third party's receipt may cut off the seller's reserved security interest.[vi]  With this in mind, in cases where the seller has a reserved title the lender considering lending against inventory in-transit should confirm the person to whom the inventory is being shipped (and whether or not it is the borrower) and the estimated transit time.

Seller's Right of Stoppage of Inventory in Transit.  The UCC also provides an unpaid seller the right to stop delivery of inventory in transit when the seller discovers that the purchaser is "insolvent."[vii]  A seller establishes a borrower's insolvency by demonstrating that the borrower has ceased to pay its debts in the ordinary course of business, cannot pay its debts as they become due, or is insolvent within the meaning of the Bankruptcy Code.[viii]

The seller's stoppage right is a powerful tool.  Like a reservation of title, it affords rights to the seller that are superior to the rights of a secured party that has a prior perfected security interest in that same inventory.  Unlike a reservation of title, the seller's stoppage right can be exercised even though title to the inventory may have passed from the seller to the borrower.  Also, the seller merely needs to notify the carrier[ix] with whom the inventory has been placed that the seller is exercising its stoppage right.  No special form of notice is required, and it need not be in writing.  Once notified, the carrier must hold and deliver the inventory as the seller directs.[x]

Although powerful, the unpaid seller's stoppage right also has limits.  The seller cannot stop delivery after any of the following events occur:

• the borrower "receives" the inventory,
• a bailee (other than a carrier) that holds the inventory acknowledges to the borrower that it holds the inventory for the borrower,
• a carrier that holds the inventory acknowledges to the borrower that it is warehousing the inventory,
• a carrier that holds the inventory reships the inventory on behalf of the borrower, or
• a negotiable document of title covering the inventory is "negotiated" to the borrower.[xi]

As illustrated below, the lender's diligence, together with documentation the borrower obtains to memorialize the occurrence of these events, can protect the priority of the lender's perfected security interest.

Borrower's Receipt.  Receipt requires "possession" of the inventory.[xii]  Possession is independent of when title or risk of loss to the inventory passes, or the shipping terms used by the parties.[xiii]  In practice, "receipt" occurs when the inventory arrives at its final destination and the borrower has control of the inventory, whether or not the inventory is actually unloaded upon arrival.[xiv]

In certain cases, possession by a third party on the borrower's behalf can also cut off the seller's rights.  For example, a third party that obtains possession of inventory in order to process the inventory for the borrower will likely constitute "receipt."[xv]  As discussed in the next section, receipt by a warehouse can also suffice, but the borrower would need an acknowledgment from the warehouse that it holds the inventory on the borrower's behalf.  Importantly, possession by a third party that is a link in transit – such as a carrier or freight forwarder – probably does not constitute "receipt" sufficient to cut off the unpaid seller's rights, even if the borrower has engaged the third party.[xvi]  In those cases, the borrower's receipt of the inventory continues to be the determinative event.  These considerations instruct a lender asked to lend against in-transit inventory to verify the destination to which the inventory is being shipped and the parties that may be engaged in the shipping process.

Bailee's Acknowledgment.  An acknowledgment to the borrower by a third party bailee (other than a carrier) that the bailee holds the inventory for the borrower also cuts off the unpaid seller's right to stop delivery.[xvii]  A common example involves inventory shipped to a third-party warehouse to be held by the warehouse on the borrower's behalf.

The UCC does not require a specific form of acknowledgment.  The best practice would be for the borrower to provide a written "notice and acknowledgment" to the bailee stating that the bailee is to hold the inventory on behalf of the borrower, which the bailee signs to acknowledge it will do so.  Condensing the acknowledgment into a single writing provides a clear indication that an acknowledgment exists and avoids having to piece together an acknowledgment from multiple writings or a course of dealing.[xviii]  As a result, a lender should require the borrower to obtain a notice and acknowledgment from a warehouse when asked to lend against inventory that is in transit to a warehouse and not the borrower's place of business.

 Carrier's Acknowledgment.  Similar to a bailee's acknowledgment, a carrier's acknowledgment to the borrower that it is providing warehouse services for the borrower will terminate the unpaid seller's right to stop delivery.  To be effective, however, the warehouse services must arise from "a contract of a truly different character from the original shipment, a contract not in extension of transit but as a warehouse."[xix]  This test would not be satisfied where a carrier provides storage services as a link in transit that are related to the underlying contract.[xx]

As logistics providers expand their businesses, they may offer their customers a "one-stop shop" for both transportation (as a carrier) and storage (as a warehouse).  A diligent lender should review the contracts between the borrower and the logistics provider to verify whether the warehouse services are distinct from the original shipping contract.  The best indication that the carrier acts as a warehouse would be the existence of a written contract for warehouse services that is separate from the shipping contract and that contains an express acknowledgment by the carrier that it is storing inventory on the borrower's behalf.

Carrier's Reshipment.  Reshipment occurs when the borrower resells the inventory to its customer while the inventory is in the carrier's possession.  Inventory that is reshipped by the carrier is not subject to stoppage by an unpaid seller.  This rule protects the borrower's customer from any dispute between the borrower and the original seller and ensures that the inventory is delivered even if the borrower may be insolvent.[xxi]  The seller need not know of the resale of the inventory by the borrower to the borrower's customer for this rule to apply.  The carrier's act of reshipping the inventory as directed by the borrower, without more, extinguishes the unpaid seller's right to stop its delivery.[xxii]

Issuance of Negotiable Document.  Inventory that is shipped by a carrier will be transported pursuant to a shipping document issued by the carrier that references the inventory.  One type of shipping document is a bill of lading, which is also a document of title.[xxiii]  Bills of lading are either "negotiable" or "non-negotiable" and list the party entitled to receive the inventory as the "consignee" on the face of the bill.  The most common indication that a bill of lading is negotiable is the use of the phrase "to order of" immediately prior to the name of the consignee.  If the inventory is shipped under a negotiable bill of lading and the bill names the borrower as "consignee," then the bill is deemed "negotiated" to the borrower and the seller's right to stop delivery terminates.[xxiv]

Seller's Security Interest Under Negotiable Documents.  Although shipping under a negotiable bill of lading cuts off the unpaid seller's right to stop delivery of inventory, the seller's procurement of a negotiable bill of lading creates a separate, but similar, right in favor of the seller.  The seller obtains a security interest in the inventory referenced in the negotiable bill when the seller procures a bill "to order of" the seller, the borrower (as buyer), or the lender.[xxv]

The security interest created by issuance of the negotiable bill of lading has characteristics similar to both the seller's right to stop delivery of inventory in transit and a reservation of title.  Similar to the seller's stoppage right, the seller obtains its security interest without regard to the parties' agreement as to when title passes.[xxvi]  Similar to a reservation of title, the security interest created upon issuance of the negotiable bill is perfected automatically without filing a financing statement.  The security interest also has priority over a lender's prior perfected security interest until the borrower obtains possession of the inventory.[xxvii]  Determining when possession occurs implicates the same considerations as when a seller has reserved title to the inventory.[xxviii]  Once again, a lender evaluating whether to assume the business risk of making loans based on the value of in-transit inventory is best served to confirm the person to whom inventory is being shipped and the timetable for delivery.

Seller's Rights After Receipt.  As previously noted, the unpaid seller's potentially superior right to the inventory ceases when the borrower obtains possession of the inventory.  However, after the borrower's receipt, a seller may assert a continued interest in the inventory based on either (a) a purchase money security interest (a "PMSI") or (b) the seller's right of reclamation.  In both instances, the lender has protections against the seller's asserted interest that mitigate its business risks.

Purchase Money Security Interest.  A seller that has provided purchase money financing to enable to purchase of inventory may obtain a superior interest over a prior-perfected lender in the form of a PMSI.  A seller can only obtain a PMSI if it has, prior to the delivery of the inventory to the borrower: (a) filed a financing statement in the appropriate filing jurisdiction that adequately describes the collateral and (b) given written notice to the prior-perfected lender of the purchase money financing.[xxix]  If the seller takes these required steps, the seller will have the first priority security interest in the inventory covered by the PMSI.  In spite of this, the lender has a practical protection.  It will know of the seller's conflicting security interest in advance of the borrower's receipt of the inventory.  The lender can reduce its risk by excluding the value of such inventory from the borrower's borrowing availability under the credit facility.

Reclamation.  If the borrower is insolvent at the time that it receives the inventory, then the unpaid seller may seek to reclaim the inventory from the borrower.[xxx]  The UCC generally limits the seller's ability to seek reclamation to a 10 day period after the borrower's receipt of the inventory.[xxxi]  However, the seller's demand to reclaim inventory that has been received by the borrower will not likely prevail against the borrower's lender.  It is generally accepted that the seller's ability to reclaim inventory is subject to the rights of a secured party that possesses a prior-perfected security interest in the inventory.[xxxii]  Therefore, unless the seller has taken the steps needed to create a PMSI in the inventory, then the lender's concerns over the unpaid seller's rights should end upon the borrower's actual receipt of the inventory.

Conclusion. An asset-based lender cannot rely solely on its prior perfected security interest when lending against in-transit inventory.  An unpaid seller retains rights in the inventory it has sold, and those rights are typically superior to the rights of a secured creditor until such time as the inventory is received by the borrower.  A lender can best quantify the attendant risks and make a reasoned credit decision only after it understands the borrower's contractual relationship with its seller and the manner in which the inventory is transported from the seller to the borrower or a third party location.

[i] The UCC should be the law applicable to disputes during the period that goods are in transit within the United States.  Non-US law could potentially apply while goods are in transit but located outside the United States.

[ii] UCC § 2-401.

[iii] UCC § 9-110 (providing rules for perfection of security interests under Section 2-401).  This rule is contrary to the first-to-file rule that generally applies when there are conflicting security interests.  UCC § 9-322(a)(1).

[iv] See, e.g., Usinor Industeel v. Leeco Steel Products, Inc., 209 F. Supp. 2d 880, 888 (N.D. Ill. 2002).  The seller could potentially maintain a superior interest if it obtains a purchase money security interest in the inventory, a topic addressed later in this article.

[v] See, e.g., Toyota Indus. Trucks, U.S.A., Inc. v. Citizens Nat'l Bank of Evans City, 611 F.2d 465, 473 (3d Cir. 1979).

[vi] Farm Credit of NW Florida, ACA v. Easom Peanut Co., 718 S.E.2d 590, 598 (Ga. App. 2011); Hong Kong and Shanghai Banking Corp., Ltd. v. HFH USA Corp., 805 F. Supp. 133, 144 (W.D.N.Y. 1992).

[vii] UCC § 2-705(1).  A seller can also stop delivery with respect to deliveries of carload, truckload, planeload or large shipments "when the buyer repudiates or fails to make a payment due before delivery."  Id.

[viii] UCC § 1-201(23).

[ix] Carriers include, among other entities, trucking companies, railroads, and steamship lines.

[x] UCC § 2-705(3)(b).

[xi] UCC § 2-705(2).

[xii] UCC § 2-103(1)(c).

[xiii] Matter of Pester Refining Co., 845 F.2d 1476, 1482 (8th Cir. 1988); In re Marin Motor Oil, Inc., 740 F.2d 220, 225 (3d Cir. 1984).

[xiv] In re Morrison Indus., L.P., 175 B.R. 5, 8 (Bankr. W.D.N.Y. 1994) (buyer did not have constructive receipt where buyer had no right to move or control the goods); In re Bill’s Dollar Stores Inc., 164 B.R. 471, 476-77 (Bankr. D. Del. 1994) (goods were "received" even though not unloaded for several days).

[xv] Donegal Steel Foundry Co. v. Accurate Products Co., 516 F.2d 583, 590 (3d Cir. 1975).

[xvi] In re Trico Steel Co., L.L.C., 282 B.R. 318, 323-325 (Bankr. D. Del. 2002), aff'd., 302 B.R. 489 (D. Del. 2003).

[xvii] Trico Steel, 282 B.R. at 325.

[xviii] Jimanji Corp. v. S.L.T. Warehouse Co., 409 So. 2d 496 (Fl. Ct. App. 1982), petition denied, Metro Bank of Dallas v. S.L.T. Warehouse Co., 417 So. 2d 330 (Fla. 1982) (letter regarding warehouse operation did not constitute a bailee acknowledgment).

[xix] UCC § 2-705, Off. Cmt. 3.

[xx] Trico Steel, 282 B.R. at 323.

[xxi] Butts v. Glendale Plywood Co., 710 F.2d 504, 505 (9th Cir. 1983).

[xxii] Id.  The direct shipment of inventory by a seller to the borrower's customer also cuts off the unpaid seller's right to stop delivery.  UCC § 2-705, Off. Cmt. 2.

[xxiii] Another shipping document that a carrier commonly issues is a waybill, which is not a document of title.

[xxiv] UCC § 2-705(2)(d); In re Murdock Machinery & Eng. Co. of Utah, 620 F.2d 767, 775 (10th Cir. 1980).  For purposes of the UCC, "negotiation" occurs upon the issuance of the bill of lading by the carrier to the borrower.  Siderpali, S.P.A. v. Judal Indus., Inc., 833 F. Supp. 1023, 1033 (S.D.N.Y. 1993).

[xxv] UCC § 2-505.

[xxvi] UCC § 2-505, Off. Cmt. 1. 

[xxvii] UCC §§ 9-110, 9-309(6).

[xxviii] UCC § 9-110 (priority of security interests arising under either Section 2-401 or 2-505).

[xxix] UCC § 9-324.

[xxx] UCC § 2-702.

[xxxi] The 2003 amendments proposed by the drafters of Article 2 of the UCC replace the "10 day period" with "a reasonable time."  However, these changes have not yet been adopted in any jurisdiction.  In addition, the 10 day period may be extended under the Bankruptcy Code to 20 days if a bankruptcy occurs and the 10 day period would expire after the date of the bankruptcy filing.  11 U.S.C. § 546(c).

[xxxii] UCC § 1-201(32) (a "purchaser" includes a person that takes an interest by the taking of a security interest) UCC § 2-702(3) (right to reclamation is subject to the rights of a good faith "purchaser" of the inventory); Los Angeles Paper Bag Co. v. James Talcott, Inc., 604 F.2d 38, 39-40 (9th Cir. 1979).  Most courts have held that the seller's interest is extinguished, while a minority of courts have held that the interest is subordinated to that of the lender.  In either case, the lender's interest would need to be satisfied first.  See also 11 U.S.C. § 546(c) (right of reclamation is "subject to the prior rights of a holder of a security interest in such goods").